Thursday, February 15, 2018

The tragedy is so few act when the collapse is predictably inevitable, but not yet manifesting in daily life.

That chill you feel in the financial weather presages an unprecedented--and for most people, unexpectedly severe--winter of discontent. Rather than sugarcoat what's coming, let's speak plainly for a change: none of the promises that have been made to you will be kept.

This includes explicit promises to provide income security and healthcare entitlements, etc., and implicit promises that don't need to be stated: a currency that holds its value, high-functioning public infrastructure, etc.

Nearly "free" (to you) healthcare: no.

Generous public pensions: no.

Social Security with an equivalent purchasing power to the checks issued today: no.

As for the implicit promises:

A national currency that holds its value into the future: no.

High-functioning public infrastructure: maybe in a few places, but not something to be taken for granted everywhere.

A working democracy in which common citizens can affect change even if the power structure defends a dysfunctional and corrupt status quo: no.

A higher education system that prepares its graduates for secure jobs in the real-world economy: on average, no.

Cheap, abundant fossil fuels and electricity: during recessionary head-fakes, yes; but as a permanent entitlement: no.

High returns on conventional capital (the kind created and distributed by central banks): no.

A government that can borrow endless trillions of dollars with no impact on interest rates or the real economy: no.

Pay raises that keep up with real-world inflation: no.

Ever-rising corporate profits: no.

You get the idea: the status quo will be unable to keep the myriad promises made to the public, implicitly and explicitly. The reason is not difficult to understand:

Governments jealously protect their right to create currency ("money") out of thin air. This is known as seigniorage. Technically, it's the profit earned by issuing "money" with a market value above the cost of production. For example, if a $100 bill costs 10 cents to produce, the central state's seigniorage is $99.90.

(Central banks are part of the central state. Even though America's central bank, the Federal Reserve, is privately owned, it nonetheless functions as the federal government's central bank.)

To reward cronies and win elections, politcos promise everyone more of everything. Major campaign donors are promised tax breaks; powerful corporations are promised government-mandated cartels or monopolies. Private banks are promised cheap credit. Public unions are promised higher wages and heftier benefits. Voters are promised more infrastructure, more education and social spending, and more entitlements.

And so on.

Funding all these ever-expanding promises with cash would require higher taxes. Any attempt to trim the gravy train promised to one group will arouse that constituency to a frenzy of lobbying and noisy proclamations of disaster if even a penny of their promised gravy train is cut.

As for raising taxes, not only is that politically unpopular, it has an economic impact: every additional dollar taken in taxes is one less dollar available to households and enterprises to spend, save or invest.

If every additional tax dollar was recycled into the economy with the same efficiency as private spending and investment, i.e. the new spending decreased household and enterprise costs proportionately, the effects might be roughly neutral or even beneficial, if the public spending leveraged some new efficiency that was available to everyone.

(If a new tax radically reduced the cost of college tuition for every college student, at least some households would be able to offset the higher taxes with significantly lower expenses. The problem with this swapping of public spending for private spending is politically powerful constituencies typically get the extra public spending, and so the citizenry end up subsidizing political favored groups rather than broadly beneficial programs that actually reduce household/ enterprise expenses.)

So how can politicos fulfill their ever-more costly promises without generating political or economic blow-back? Borrow and/or create the money needed to fund the promises. Actually, these are one mechanism, as Japan has shown: the government borrows a trillion, then the central bank creates a trillion out of thin air and buys the government bond with the new trillion.

If central banks can keep interest rates low, the cost of servicing the new debt is modest--or the interest can be paid with more borrowed money. If the central bank buys the new debt, it's like a perpetual-motion financial machine: the government can borrow unlimited currency, as every new Treasury bond is helpfully purchased by the central bank with new currency created out of thin air.

You see the self-reinforcing feedback loop this creates.The ease of borrowing and the initially modest costs of servicing this additional debt encourages more reliance on borrowing as the politically practical way to meet all the promises while placating powerful constituencies and winning re-election.

The consequences of runaway currency creation/government borrowing are not immediately visible, as the financial system's buffers compensate / subdue the adverse effects.

In other words, the unlimited money-creation/borrowing regime appears stable and sustainable as the risks and consequences are buried in the financial system as a whole.

But the apparent lack of consequences doesn't mean there are no consequences. It means the imbalances and extremes are piling up beneath the surface as the system's buffers thin. New extremes are required to keep the system afloat, but there doesn't seem to be any upper limit on money creation or new government debt.

Until the buffers give way, and all the accumulated consequences manifest in sudden fashion. Here is a chart of the black market ("free") Venezuelan Bolivar to the U.S.dollar (data courtesy of dolartoday.com).

We're assured "that can't happen here," but history tells us that eventually it always "happens here." Ten years ago, few middle-class Venezuelans would have believed their national currency could sink to the point that a 100,000 bolivar bill was worth a mere 41 cents in US dollars.

The chart reveals the dynamic: the currency can be debauched for years with little apparent consequence, and then the buffers suddenly collapse and the currency is essentially worthless.

The collapse of the purchasing power of a currency can be slow or fast. Ten years of 10% annual inflation in an economy of near-zero wage inflation will do the trick, or a sudden crisis of faith creates a bidless market for the currency: nobody wants to part with anything of value for the currency.

The terrible financial hurricane wipes out all the accumulated savings (i.e. accumulated purchasing power) of everyone holding the currency as a "store of value." Only those who transferred their currency into durable stores of value before the collapse (stores of value that the desperate government can't expropriate) conserved their savings/ purchasing power.

Just as structures weaken imperceptibly before they collapse in a heap, the undermining of national currencies by excessive issuance of currency/credit and government debt is also imperceptible. The politicos and functionaries in charge of the debauching of the currency are at first nervous that the market might sniff out the debauchery; but the complacent acceptance of their fraud by the markets and the public gives them the green light to increase the issuance of currency and debt.

Their confidence that they can get away with paying yesterday's promises with money borrowed from the future essentially forever builds into an inevitably fatal hubris.

The tragedy is so few act when the collapse is predictably inevitable, but not yet manifesting in daily life. Screaming but we wuz promised won't nullify the hurricane.

Tuesday, February 13, 2018

The hope of 1968 that public demonstrations can actually change the power structure has been lost.

1968 was a tumultuous year globally and domestically. The Prague Spring in Czechoslovakia--a very mild form of political and cultural liberalization within the Soviet bloc--was brutally crushed by the military forces of the Soviet Union.

The general strikes and student protests of May 1968 brought France to a standstill as demands for social and political change called the entire status quo into question.

On the other side of the planet, the Cultural Revolution was remaking China's still-youthful revolution, to the detriment of the political status quo, the intelligentsia and the common people.

The U.S.was convulsed with assassinations, civil unrest and mass demonstrations against the war in Vietnam and the political status quo (the Democratic Party convention in Chicago).

Ironically, much of the world was benefiting from two decades of rising prosperity and the demise of colonialism. When expectations exceed actual opportunities, discontent is the result. When the power structure is deaf to the discontent, a cycle of repression and disorder feed on each other.

Fifty years on, the ghosts of 1968 are still with us. With the advantage of hindsight, 1968 was the culmination of the belief that it was still possible for the common people to change the political and social order in a positive fashion-- to remake the status quo power structure into something more humane, accessible, just and fair.

The Western status quo bent but did not break. Nothing in the developed-world power structures actually changed. The status quo did break down in China, but the breakdown was not liberating; it was a catastrophe of injustice and destruction without precedent.

A new winter of discontent is chilling the air. Though the current state of affairs seems quite different from that of 1968, the basic context is eerily similar: decades of economic growth have ushered in widespread prosperity, but the benefits and power have gone disproportionately to the few at the top of the wealth-power pyramid.

The status quo power structures are deaf to the discontent of the common people, and respond with blandishments (Universal Basic Income, etc.), propaganda and a spectrum of repression.

The two greatest visions of a future dystopia were George Orwell’s '1984' and Aldous Huxley's 'Brave New World.' The debate, between those who watched our descent towards corporate totalitarianism, was who was right. Would we be, as Orwell wrote, dominated by a repressive surveillance and security state that used crude and violent forms of control? Or would we be, as Huxley envisioned, entranced by entertainment and spectacle, captivated by technology and seduced by profligate consumption to embrace our own oppression? It turns out Orwell and Huxley were both right. Huxley saw the first stage of our enslavement. Orwell saw the second.

We have been gradually disempowered by a corporate state that, as Huxley foresaw, seduced and manipulated us through sensual gratification, cheap mass-produced goods, boundless credit, political theater and amusement. While we were entertained, the regulations that once kept predatory corporate power in check were dismantled, the laws that once protected us were rewritten and we were impoverished. The state, crippled by massive deficits, endless war and corporate malfeasance, is sliding toward bankruptcy. We are moving from a society where we are skillfully manipulated by lies and illusions to one where we are overtly controlled.

It's also worth re-reading Mario Savio's extemporaneous speech to the Free Speech Movement's sit-in on December 3, 1964, on the campus of the University of California at Berkeley. Though the speech predates the Prague Spring and the Paris general strike by four years, it embodies the core dynamic of those social uprisings: the system itself is fundamentally flawed, and we are the raw material and product that keep the system operating.

There is a time when the operation of the machine becomes so odious, makes you so sick at heart, that you can't take part; you can't even passively take part, and you've got to put your bodies upon the gears and upon the wheels, upon the levers, upon all the apparatus, and you've got to make it stop. And you've got to indicate to the people who run it, to the people who own it, that unless you're free, the machine will be prevented from working at all!

The hope of 1968 that public demonstrations can actually change the power structure has been lost. The ghosts of 1968 inform us that there is no reforming the status quo power structure, there are only simulacrum reforms that fulfill the PR requirements of being seen as effecting reform. But people are losing faith in do-nothing policy tweaks; those tossed aside as detritus by the winner-take-most status quo realize the system is failing not just those on the margins but the entire citizenry. Those who look at the stripmined seas, polluted air, depleted soils and aquifers know the system is also failing the planet.

The system needs us as raw material, as "product," as consumers of the output of the machine. That we are consumed by the process--that awareness has faded into the shadows inhabited by the ghosts of 1968.

Sunday, February 11, 2018

The illusion that risk can be limited delivered three asset bubbles in less than 20 years.

Has anything actually changed in the past two weeks? The conventional bullish answer is no, nothing's changed; the global economy is growing virtually everywhere, inflation is near-zero, credit is abundant, commodities will remain cheap for the foreseeable future, assets are not in bubbles, and the global financial system is in a state of sustainable wonderfulness.

As for that spot of bother, the recent 10% decline in stocks: ho-hum, nothing to see here, just a typical "healthy correction" in a never-ending bull market, the result of flawed volatility instruments and too many punters picking up dimes in front of the steamroller.

Now that's winding up, we can get back to "creating wealth" by buying assets--$2 million homes in Seattle that were $500,000 homes a few years ago, stocks, bonds, private islands, offshore wealth funds, bat guano, you name it. Just borrow whatever you need to borrow to buy more.

(But don't buy bitcoin. No no no, a thousand times no. It is going to zero, Goldman Sachs guaranteed it.)

Ahem. And then there's reality: something has changed, something important.What changed? The endlessly compelling notion that risk has magically vanished as the result of financial sorcery is now in doubt. If risk hasn't been made to disappear, and even worse, can't be corralled into a shortable instrument like VIX, then--gasp--every asset and instrument might actually be exposed to some risk.

As I've noted many times here, risk cannot be made to disappear; it can only be transferred onto others or off-loaded into the financial system itself. Risk can be cloaked or masked, and indeed, that is the beating heart of financial alchemy: we can eliminate risk by hedging via exotic instruments.

Once risk has been vanquished, then we can safely invest in all sorts of high-yield ventures that were once risky: junk bonds, emerging market debt, private wealth funds and so on.

But if risk cannot be destroyed, then where is it? If we can locate and isolate it, then we can hedge it, right?

But what if risk has been pushed into the vast machinery of the global financial system itself? This was the unwelcome (and as yet unlearned) lesson of the 2007-08 Global Financial Meltdown: risk, we were told, was confined to the subprime mortgage corral, and if you avoided that corral, your exposure to risk was near-zero.

That turned out to be false. The belief that risk exposure is near-zero generates an irresistible desire to load up on high-yield riskier assets because, hey, why not? If risk is near-zero, why leave all that low-hanging fruit on the tree?

This is a self-reinforcing feedback loop: the higher the yields available on risk assets, and the lower the perceived risk exposure, the greater the incentives to move more borrowed money into ever-riskier assets, which then pushes systemic risk ever higher.

The end-game of this self-reinforcing feedback loop is collapse, as risk inevitably emerges where it is least expected. Home mortgages were safe and boring. Well, not quite, after financial alchemy was applied to vanquish risk and thus unleash enormously profitable financialization.

Nobody knows where systemic risk might emerge, or how much risk exposure is lurking in assets. What was once safe is now less certainly safe. So where do you earn those fat returns without risk, the returns the world has come to see as entitlements due capital everywhere, at all times?

The illusion that risk can be limited delivered three asset bubbles in less than 20 years. Each bubble collapse caused more structural damage, and each central bank "save" introduced higher levels of systemic fragility, which is another way of saying systemic risk.

Though no one in the financial sector dares say this in public, the possibility that central banks can no longer sustain the illusion that risk has been vanquished is now front and center. If risk can't be corralled and quantified, then it can't be offset with any degree of confidence. If risk can't be corralled and quantified, it can't be offloaded onto unsuspecting others without the possibility that the system itself will collapse once the risk that's been piling up in the global machinery manifests.

Something has changed, but nobody dares talk about it. That tells those who listen to what's not being said something of great value.

Thank you, Mark B. ($50), for your marvelously generous contribution to this site -- I am greatly honored by your support and readership.

Friday, February 09, 2018

How can central banks "retrain" participants while maintaining their extreme policies of stimulus?

Human habituate very easily to new circumstances, even extreme ones. What we accept as "normal" now may have been considered bizarre, extreme or unstable a few short years ago.

Three economic examples come to mind:

1. Near-zero interest rates. If someone had announced to a room of economists and financial journalists in 2006 that interest rates would be near-zero for the foreseeable future, few would have considered it possible or healthy. Yet now the Federal Reserve and other central banks have kept interest rates/bond yields near-zero for almost nine years.

The Fed has raised rates a mere .75% in three cautious baby-steps, clearly fearful of collapsing the "recovery."

What would happen if mortgages returned to their previously "normal" level around 7% from the current 4%? What would happen to auto sales if people with average credit had to pay more than 0% or 1% for a auto loan?

Those in charge of setting rates and yields are clearly fearful that "normalized" interest rates would kill the recovery and the stock bubble.

As many of us have observed, "official" inflation of less than 2% does not align with "real-world" inflation in big-ticket items such as rent, healthcare and college tuition/fees. A more realistic inflation rate is 7%-8% annually, especially in the higher-cost regions of the US.

But setting that aside, there is a puzzling asymmetry between low official inflation and the unprecedented expansion of money supply, debt and monetary stimulus (credit and liquidity). To date, most of this new money appears to be inflating assets rather than the real world. But can this asymmetry continue for another 9 years?

3. Stock markets are soaring but sales and profits are stagnant. Everyone knows central banks are still pumping billions of dollars per month into the financial system, and this (coupled with central bank purchases of stocks and bonds) has been pushing stocks sharply higher for the past 9 years, with only a few hiccups along the way.

This is pushing valuations out of alignment with traditional metrics of valuing assets such as sales and profits--a process known as "price discovery." In essence, traders and investors have habituated to central banks driving private-sector markets higher, not because the assets are generating more value or profits. but simply as a function of centralized money creation and asset purchases.

All of these extremes generate mal-investment, diminishing returns and perverse incentives for ramping up unproductive and risky speculation, leverage and debt. Yet the central banks have trapped themselves in this risky trajectory because they've pushed the accelerator to the floorboard for 9 years. Any extreme held in place for 9 years has long slipped from "temporary" to permanent.

Participants have now habituated fully to central banks extreme stimulus of financial markets, and in a sense they've forgotten how to price assets based on real-world private-sector measures.

How can central banks "retrain" participants while maintaining their extreme policies of stimulus? The only possible answer is: they can't.

This essay was drawn from Musings Report 2018:1. The Musings Reports are emailed weekl to constributors, subscribers and patrons. Than you for your financial support of my work.

Wednesday, February 07, 2018

There's a place for fancy technical interpretations, but sometimes a basic chart tells us quite a lot. Here is a basic chart of the Dow Jones Industrial Average, the DJIA. It displays basic information: price candlesticks, volume, the 50-week and 200-week moving averages, RSI (relative strength), MACD (moving average convergence-divergence), stochastics and the MACD histogram. These kinds of charts are free (in this case, from StockCharts.com).

This is an ugly chart.It's ugly because the decline to date is still far above support levels (the 50-week and 200-week moving averages) and the indicators have only just started registering sell signals. This means that price will have to decline a lot more to test previous support and send the indicators to levels that signal reasonably low-risk entries.

In other words, there's nothing suggesting this is a buying opportunity in this chart. Rather, it suggests a decline of another couple thousand points would be perfectly normal in a weekly chart with a big fat MACD sell cross and sinking RSI and stochastics.

Even a decline of 6,000 points to 18,900 would be technically very typical of an over-stretched asset snapping back to long-term support.

Buying the dip is a good way to experience churning whipsaws. Up 350 points, then down 450. Nice if you can second-guess the trading bots, not so nice if you assume every dip should be bought because the market always rallies from every dip. Maybe, maybe not.

Something changed, and no, it isn't just the easy-money sell-volatility trade blew up. All the other easy-money sure-thing momentum plays are now in doubt: the buy the FAANG stocks sure-thing, the buy the DJIA sure-thing, the buy the New Nifty 50 (Boeing et al.) sure-thing, the buy emerging bonds, stocks and and FX sure-thing, the buy bonds because interest rates will continue drifting lower forever sure-thing, the buy utilities sure-thing (the 15% drop since December 1 put a dent in that sure-thing), the buy REITs sure-thing, and so on.

If the momo trends that enabled every trading bot to make money by buying the dip and selling volatility go away, how will everyone make money? The short answer is that it suddenly becomes much more difficult to make money and keep it.

God forbid that money managers and punters would have to actually do their homework and pick stocks based on fundamentals. And what happens when those fundamentals start deteriorating as "growth" slides into "stagnation"?

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